Month: July 2016

Submitted by Eugen von Bohm-Bawer via Bawerk.net,

Imagine the financial crisis knocked you out and you did not wake up from the coma that followed until this day. Then, presented with the following three charts you were asked to guess where the federal funds rate was trading. Given the fact that

• the core CPI is on a steep uptrend and currently over the arbitrarily set 2 per cent target;
• unemployment below what the FOMC regards as full employment and;
• GDP running at a rate far above the Federal Reserve’s own estimates of so-called potential;

we are certain most people would say the Federal Reserve, still very much data dependent (yes, that is what they claim), would be responsible enough to have lifted the rate far above its long term average to maintain positive real rates in order to cool down the economy. This is what modern Keynesianism- and Monetarism teaches the zealous acolytes populating the world central banks after all.  In short, you would say the Federal Funds rate would be in the vicinity of five per cent.

Being told the Federal Funds rate is close to the zero lower bound (which turned out to be no bound after all) you may enquire as to whether the Federal Reserve had just slashed rates to fend off an imminent recession. Presented with the next chart whereby the abovementioned information is translated into a simple central bank rule, as proposed by John Taylor in the 1990s, you would probably be frightened back into a coma again. While the large red area prior to the housing bubble bust helped form a global crisis on a scale the world hadn’t seen since the 1930s, the current level of monetary folly completely dwarfs even the Maestro`s insanity. The amount of capital consumption and misallocation today must be absolutely unprecedented and it logically follows that the inevitable bust that currently brews under the fragile complacency in financial market is of equal proportions. For every action follows an equal and opposite reaction; nowhere is this truer than in monetary policy. The red area comprising the difference between the Taylor rule and the actual Fed Funds rate (not to mention the area between the Taylor rule and the shadow rate that tries to mimic the effect of forward guidance and QE) has never ever been larger than during this bubble. We added Greenspan’s and Yellen’s own rules, and even by their standard rates should be far higher by now.

As a side-note, we define a bubble as an economic activity that is not self-sustaining and by extension capital consuming.

While our definition of a bubble is more robust than those that focus solely on financial valuation metrics, there is obviously a high degree of causal connection between the two. Consider the chart below depicting household net worth as share of their disposable income; over time, this ratio should be mean reverting. Household asset are what produces the output ultimately used to pay back households their income; since valuation should, in theory at least, be the discounted stream of future cash flows then it follows that the ratio between the two revert back to its long term mean. If the value of household assets moves too far away from underlying fundamentals, the carrying cash flow cannot support the price paid for it and a bubble has formed. A bubble that will eventually deflate.

We use the mean from 1952 (start of data series) to 1987 (when Greenspan took over at the Fed) as our benchmark. Whenever valuations strayed too far away (defined as two standard deviations) it moved back down to its mean. Likewise for under-valuations as happened in the mid-1970s. However, as Greenspan floored the monetary pedal from 1987, valuations seem to have reached what looks like a permanently high plateau. Neither the dot-com nor the housing bubble were allowed to correct itself, as it should, due to monetary interventions. That said, even with monetary interventions they never managed to sustain elevated levels at 6 to 6.5 times income for very long. With the madness presented above, it should come as no surprise that we are once again at these extreme levels and that from here relative valuation has nowhere to go but down.

The Fed has painted themselves so far into a corner that they cannot avoid stepping on some wet paint soon. A symbolic 25 basis point hike in December and financial Armageddon seemed to follow. Commodity prices crashed as global dollar funding dried up. Capital outflow from emerging markets became an acute problem. That is why, despite all the data dependence, the Fed is unable to follow through on their incessant threats to raise rates. The house of card built on continuation of ample dollar flows at low rates is too fragile to withstand even the slightest disruption; such as an insignificant 25 basis points.

Even worse, hiking the dollar rate when global central banks, like the ECB and BoJ are moving full throttle forward with their QE programs makes the situation even more precarious for the Federal Reserve. Stunning as it may be, but global QE, in USD term, is currently running at a record rate with monthly liquidity expansions of USD150 – 180bn (h/t ZeroHedge).

We said last year that the FOMC would never dare do more than 25 to 50 basis points and we still stick with that call. Despite the “overheating economy” in a Keynesian sense, the underlying fundamentals are getting weaker by the day and the financial system is destined to crash.

One day the FOMC will run out of excuses and hike, setting in motion the proverbial butterfly that rocks the world.

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Yesterday we quoted from a surprising report by Credit Suisse, according to which after surveying numerous clients, the bank had come across “almost no one who seems to have outperformed or made decent returns this year.”  While not quite as extreme, the latest HSBC performance report confirms that the broader market is outperforming the vast majority of hedge funds in 2016.

But more surprising was Credit Suisse’s admission that “we have never had so many client meetings starting with statements such as ‘we are totally lost‘.”  The main cited reason for the confusion is that “clients are close to being as bearish on equities as we can remember. Clients do not find equity valuations attractive enough to compensate for the macro, political, earnings and business model risks.”

And yet, with everyone “bearish” the market continues to levitate higher to record highs (on ever less volume) most recently today, when it touched a new all time high shortly after the US reported the worst annual growth in GDP since 2010, further confusing traders who as we said yesterday, in a scramble for performance have succumbed to the oldest error in the book: performance paralysis, better known as a herd-chasing panic.

Today we got confirmation of just that, when in a report by BofA’s Savita Subramanian, the strategist asks the following rhetorical question “if everyone is talking about how bearish everyone else is…”

Specifically, she takes on the Credit Suisse allegation of pervasive pessimism and further asks if “Is positioning really that bearish?” This is her answer: 

Defensive positioning was likely a key driver of strong equity returns this year. While some indicators still suggest bearish sentiment – our Sell  Side Indicator indicates that equity sentiment is at a 4-year low, and our Global FundManager Survey indicates that cash balances are near an all-time high – others suggest positioning has gotten more bullish.

Actually, instead of more bullish, perhaps a better term is “confused”, because as BofA adds, active managers are now more exposed to beta than they have been since 2008.

In other words, instead of taking “active” advantage of stock dispersion and alpha generation, all the “smart money” is doing, is simply adding leverage to broader market surrogates, and doing what every other investor at home can do for free: ride the S&P500. The only issue is that “active managers” collect a fee for doing just that.

That said, it does appear that contrary to what they say, what investors actually do is something else, in the process turning the most long in one year, if only according to BofA:

“With the rally off of February’s lows driven largely by cyclical reflation plays, cyclical vs. defensive sector exposure is now the highest we have seen since 2012. Performance of equity long-short funds imply the highest net long position since July 2015 (Exhibit 1). See “Mixed signals from positioning metrics” inside for more details.”

So how can one summarize this perplexing trifecta of “totally lost” investors, who are “as bearish on equities as we can remember“, yet who are “the most long in one year“? Perhaps with a picture:

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Submitted by John Kartch and Alexander Hendrie via Americans for Tax Reform,

Hillary Clinton has made clear she intends to dramatically raise taxes on the American people if elected. She has proposed an income tax increase, a business tax increase, a death tax increase, a capital gains tax increase, a tax on stock trading, an "Exit Tax" and more (see below). Her planned net tax increase on the American people is at least $1 trillion over ten years, based on her campaign’s own figures.

Hillary has endorsed several tax increases on middle income Americans, despite her pledge not to raise taxes on any American making less than $250,000. She has said she would be fine with a payroll tax hike on all Americans, she has endorsed a steep soda tax, endorsed a 25% national gun tax, and most recently, her campaign manager John Podesta said she would be open to a carbon tax. It’s no wonder that when asked by ABC's George Stephanopoulos if her pledge was a "rock-solid" promise, she slipped and said the pledge was merely a “goal.” In other words, she's going to raise taxes on middle income Americans.

Hillary’s formally proposed $1 trillion net tax increase consists of the following:

Income Tax Increase – $350 Billion: Clinton has proposed a $350 billion income tax hike in the form of a 28 percent cap on itemized deductions.

 

Business Tax Increase — $275 Billion: Clinton has called for a tax hike of at least $275 billion through undefined business tax reform, as described in a Clinton campaign document.

 

“Fairness” Tax Increase —$400 Billion: According to her published plan, Clinton has called for a tax increase of “between $400 and $500 billion” by “restoring basic fairness to our tax code.” These proposals include a “fair share surcharge,” the taxing of carried interest capital gains as ordinary income, and a hike in the Death Tax.

But there are even more Clinton tax hike proposals not included in the tally above. Her campaign has failed to release specific details for many of her proposals. The true Clinton net tax hike figure is likely much higher than $1 trillion. For instance:

Capital Gains Tax Increase — Clinton has proposed an increase in the capital gains tax to counter the “tyranny of today’s earnings report.” Her plan calls for a byzantine capital gains tax regime with six rates. Her campaign has not put a dollar amount on this tax increase.

 

Tax on Stock Trading — Clinton has proposed a new tax on stock trading. Costs associated with this new tax will be borne by millions of American families that hold 401(k)s, IRAs and other savings accounts. The tax increase would only further burden markets by discouraging trading and investment. Again, no dollar figure for this tax hike has been released by the Clinton campaign.

 

“Exit Tax” – Rather than reduce the extremely high, uncompetitive corporate tax rate, Clinton has proposed a series of measures aimed at inversions including an “exit tax” on income earned overseas. The term “exit tax” is used by the campaign itself. Her campaign document describing this proposal says it will raise $80 billion in tax revenue, but claims some of the $80 billion will be plowed into tax relief. How much? The campaign doesn't say.

 

This proposal completely fails to address the underlying causes behind inversions: The U.S. 39% corporate tax rate (35% federal rate plus an average state rate of 4%) and our "worldwide" system of taxation, which imposes tax on all American earnings worldwide. The average corporate rate in the developed world is 25%. Thirty-one of thirty-four developed countries have cut their corporate tax rate since 2000. The U.S. has not. Hillary's plan moves in the wrong direction.

ATR is tracking Clinton’s full tax record at its dedicated website, HighTaxHillary.com

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While the main event in today’s European bank stress test was leaked moments ago, when Monte Paschi board member Turicchi said that the bank has finalized a bank consortium for a critical capital hike, suggesting that contrary to last minute jitters the bank has found the needed number of willing banks to provide €5 billion in fresh capital it needs resulting in the bank’s 3rd bailout in the past 2 years – this one courtesy of the private sector – there may still be some surprises.

The following preview explains what are the main things to watch for in today’s release.

The latest round of European banks’ stress test results today may highlight vulnerability of some of the largest banks but could also act as a trigger for much-needed reforms, analysts say.

• The results, due at 9pm London time, may remind investors of Italy’s difficult banking situation, and pose downside risks for the euro, say FX strategists; Monte dei Paschi di Siena (BMPS), the ailing lender that was tested, will publish 2Q numbers after European markets close Barclays says any sign there’s progress toward fixing issues in Italy’s banks could trigger a modest euro relief rally.
• ABN Amro analysts say the test is a “missed opportunity” to do a fuller and deeper health check of the banking system in Europe

WHAT’S HAPPENING?

• Just 51 banks with at least EU30b in assets have been tested; that’s down from 123 banks in the previous exercise in 2014; represents ~70% of total EU bank assets
• No bank from Portugal, Cyprus or Greece is included
  • ABN Amro analyst Nick Kounis says the exclusion of 72 smaller banks will significantly reduce the test’s coverage and impact, especially as the smaller banks are the least sound in some countries; of the banks that failed in 2014, only BMPS is being tested
  • Risk types covered by the tests will include credit risk and securitization, market risk, sovereign risk, funding risk and operational and conduct risks; the latter wasn’t assessed in 2014
• The banks are measured against two scenarios, baseline and adverse, covering the three years through 2018
  • Barclays analyst Mike Harrison says in general the toughest year in the 2016 stress test is slightly more gentle than the 2014 exercise; except for the inflation/deflation stress
• Unlike 2014, the results won’t identify banks that passed or failed and no capital hurdle has been set; CET1 ratios will be published
  • “The aim of the 2016 exercise is rather to assess remaining vulnerabilities and understand the impact of hypothetical adverse market dynamics on banks,” the EBA said
  • Banks will also be tested for conduct risk in this year’s exercise, a component not part of prior tests
  • The stress test outcomes will feed into the Supervisory Review and Evaluation process (SREP) of the banks which is expected this year, including setting the Pillar 2 bank-specific requirements
  • If the tests show that banks might breach their total SREP capital requirements (TSCR) under a stressed scenario, regulators can provide capital guidance and impose tougher capital requirements, Fitch credit company says
  • They can ask banks to revise their capital plans and suspend dividend payments; the EBA also leaves open the possibility of regulators revisiting banks’ SREP assessments and TSCR in the event of an imminent TSCR breach

WHAT TO EXPECT

• The test isn’t expected to lead to an increase of the overall level of capital demand in the system, BofAML analysts, led by Richard Thomas, write in client note
  • Expect market players to extrapolate from the stress test to an assessment of the impact on SREP levels, Thomas and team say
• Monti dei Paschi is in focus as the government could try to use the results to seek to waive bail-in and state aid rules so the state can support the financial sector, Rabobank analysts say in client note
• JPMorgan analyst Marco Protopapa says any systemic solution to Italy’s banking situation would require that senate reform isn’t rejected in the autumn referendum
• How the region responds is an important signal about how sensitive European policymakers are to politics after Brexit, which is important for Italy given the vote later this year on constitutional reform and the growing support for the populist Five Star Movement
• Deutsche Bank’s Marco Stringa says a solution to Italian large stock of NPLs is necessary to avoid a slowing in the pace of the already disappointing Italian economic recovery
• Societe Generale credit analysts led by Paul Fenner-Leitao say there’s scope for other banks to surprise on the downside, while both Deutsche Bank and Commerzbank both fared poorly in mock stress tests performed by SG’s equity analysts
  • The adverse scenario assumptions for Austrian equity prices and CEE recessions are notably bearish, they add
• Barclays analysts say any bank with less than (say) a 200bp buffer in the adverse scenario vs. the 5.5% level could face extra scrutiny – either from regulators or the market
  • This would imply that Deutsche Bank, BNP Paribas and UniCredit are potentially vulnerable as well as BMPS, they say

WHAT THE RESULTS MEAN FOR MARKETS

• If today’s stress tests show a drag from lower net interest income, that could spur speculation the ECB will refrain from further cuts in the deposit rate or prolonging QE, ScotiaBank analysts Alan Clarke and Frederic Pretet write in client note
• Fitch says once stress test results are published, greater visibility on when AT1 payments might be interrupted should bolster investor confidence in the market
  • This should support the development of this market, which would be positive for capital planning for EU banks that still need to build up regulatory capital buffers and need to issue securities that could be used for bail-ins, Fitch said yday

HOW TO TRADE IT FOR BANKS

• Analysts at TD Securities say an updated snapshot of the size of the Italian banking sector’s capital shortfall should provide the incentive to finalize plans to solve the problem; while the knee-jerk reaction may be negative, markets will quickly focus on plans for a bail-out in the following weeks
• Barclays analyst Mike Harrison agrees fixing Monte could trigger a relief rally in the sector; but the absence of a systemic solution to Italian NPLs means that move may be limited sp he favors more defensive banks such as ABN AMRO, Swedbank and Virgin Money
  • Any rally could favor higher beta banks in the core including SocGen, as well as higher quality Italian names like Intesa
  • Given the build-up in press speculation, there could though be a severely negative market reaction if there’s no ‘solution’ for BMPS, he says
  • For Deutsche, the immediate risk around the stress test is that the capital market’s perception of the group is enough to warrant some form of intervention, he adds
• ABN Amro analysts say the results will have a limited impact on European bank fixed income markets due to the exclusion of almost all of the failed banks from 2014, the lack of a pass/fail result and the lack of immediate requirements for banks to conform
• Good news for Italian banks would probably be good news for the European banking sector as a whole; could also slow the underperformance of EMU equities relative to US stocks, Patrick Moonen, strategist at NN investment Partners says
• SG analysts expect a compromise on the Italian banking sector could lead to some confidence in the euro area banking sector, although credit demand may continue to be dampened by high uncertainty and low growth prospect; and banks have a lot of issuance still to do over the near to medium term in order to comply with TLAC and MREL
• And investors may see very low ‘stressed’ core tier 1 ratios as a sign of weakness and (potentially) a need for capital; “at best this could get shrugged off by the market. At worse, it could remind investors all isn’t well in Europe even five or six years after the crisis”

FOR RATES

• While there may be some impact on the bank asset prices, most analysts are sanguine about the impact on the sovereign bond markets, especially given the ongoing ECB QE program with SG analysts saying public backstops are likely and desirable, and won’t have adverse consequences on BTP spreads
• Rabobank analysts expect only short-lived and relatively small market reaction in rates on Monday morning
  • Goldman Sachs analyst Francesco Garzarelli sees limited impact on BTPs even on any state interventions in banks as ECB likely to extend its QE program
• Monte Paschi’s announcement of 2H earnings could totally eclipse the stress test results in terms of market impact at the open on Monday morning, says BofAML’s Richard Thomas

MONTE PASCHI

Here are the results just announced by the one bank everyone’s attention will be focused on when the stress test details are revealed:

• 2Q Net income EU208.8m vs est. EU54m loss (6 ests.) ; 1H Net income: €302m; of that however €134 million is a benefit from tax income.
• 2Q rev. EU1.16b vs est. EU1.09b (8 ests.)
• 2Q NII EU486.9m
• 2Q net commissions EU483.8m
• 2Q loan loss provisions EU372.4m
• Transitional CET1 ratio 12.1% end-June vs 11.7% end-March
• La Stampa adds that Monte Paschi approved the sale of €27.7BN in bad loans at a price that is 33% of “value”

Source: Bloomberg

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July may have been a good month for the S&P 500, which is up over 3.5%, generating more than half of the S&P’s entire YTD 2016 return (6.4%) in just one month, but it was another painful month for the active investing “smart money” – of the roughly 40 (rotating) marquee names in our hedge fund tracking universe, only one is beating the broader market this month. This is a problem because as the recent surge in redemptions has shown, LPs no longer care about “beating the benchmark”, and instead are mostly focused on out (or rather under) performing the S&P 500.

The list below, sourced from HSBC, shows just how difficult it has been for most hedge funds to generate respectable performance in the month of July.

For the full year, things are slightly better, with about a dozen names outperforming the S&P500 YTD, and posting respectable double digit returns. Curiously, we find that the worst performing hedge fund of 2014, the Russian Prosperity Fund, is one of the best performers of 2016.

Finally, here is the breakdown of the Top 20 best and worst hedge funds for 2016: at the top we find the relatively unknown, smallish $115 million Dorset Energy Fund, which was also the worst performing of 2015. The worst performer according to HSBC in 2016: Odey, who as we noted earlier this week, has had a very tumultuous 2016 so far.

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Submitted by John Mauldin via MauldinEconomics.com,

I think it’s possible that the Fed will push rates below zero when the next recession arrives.

I explained why a few months ago in my free weekly column, Thoughts from the Frontline, at Mauldin Economics.

In that regard, something important happened recently. And not many people noticed. I’ll do a quick review to explain.

In Congressional testimony last February, a member of Congress asked Janet Yellen if the Fed had legal authority to use negative interest rates. Her answer was this:

In the spirit of prudent planning we always try to look at what options we would have available to us, either if we needed to tighten policy more rapidly than we expect or the opposite. So we would take a look at [negative rates]. The legal issues I'm not prepared to tell you have been thoroughly examined at this point. I am not aware of anything that would prevent [the Fed from taking interest rates into negative territory]. But I am saying we have not fully investigated the legal issues.

So as of then, Yellen had no firm answer either way.

A few weeks later, she sent a letter to Rep. Brad Sherman (D-CA). He had asked what the Fed intended to do in the next recession and whether it had authority to implement negative rates.

She did not directly answer the legality question, but Sherman took the response to mean that the Fed thought it had the authority. Yellen noted in the letter that negative rates elsewhere seemed to be having an effect.

(I agree that they are having an effect; it’s just that I don’t think it’s a good one.)

Yellen’s claims are a clear sign the Fed is prepared to dive

Fast-forward a few more weeks to Yellen’s June 21 congressional appearance. She stated that the Fed does have legal authority to use negative rates but denied any intent to do so.

“We don't think we are going to have to provide accommodation, and if we do, [negative rates] is not something on our list.”

I’m concerned about the legal authority question. If we are to believe Yellen’s sworn testimony to Congress, we know three things:

1. As of February, Yellen had not “fully investigated” the legal issues of negative rates.
2. As of May, Yellen was unwilling to state the Fed had legal authority to go negative.
3. As of June, Yellen had no doubt the Fed could legally go negative.

When I wrote about this in February, I said the Fed’s legal staff should be disbarred if they hadn’t investigated these legal issues. Clearly they had.

Bottom line: by putting the legal authority question to rest, the Fed is laying the groundwork for taking rates below zero.

I’m sure Yellen was telling the truth when she said in June that the Fed had no such plan. But, plans change.

The Fed says it's data dependent. If the data shows we’re in recession, I think it is very possible the Fed will turn to negative rates to boost the economy.

Except, in my opinion, it won’t work.

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